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In the trade example below - you have two buy put and two sell puts. One buy put is on 490 and the other is at 430, but also I am selling two puts at 460.
Since the price range of AAPL already is on 545, why will someone make the trade below?
Trade: BUY 1 BUTTERFLY: JUL12 AAPL
Over 490 = Max Loss: $240
460 = Max Gain: $2760
Under 430 = Max Loss: $240
One way to look at a butterfly is to break it into two trades. A butterfly is actually made up of two verticals...
One is a debit vertical: buy 490 put and sell the 460 put. The other is a credit vertical: sell a 460 put and buy a 430 put.
If someone believes Apple will fall to 460, that person could do a few things. There are other strategies but this just compares the three common ones: 1) Buy a put. This is expensive and if the stock only goes to 460 you overpay for it. 2) Buy a put vertical. This is less expensive because you offset the price of your put. 3) Buy a butterfly. This is cheapest of the three because you have the vertical in #2 as well as a credit vertical on top of that to offset your cost.
The reason why someone would use the butterfly is to pay less upfront while capitalizing on a fall to 460. Of the three, this would be the better strategy to use if that happens. But REMEMBER that this only applies if the trader is right and it goes to 460. There is always a trade off for every strategy that the trader must be aware of.
If the trader is wrong, and Apple goes to say 400, the put (#1) would make the most money and the butterfly(#3) would lose money while the vertical (#2) would still gain. So that is what you're sacrificing to get the benefits of the butterfly.
Also helps to draw a diagram to compare the strategies.
